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Financial Reform to Address Systemic Risk

Bernanke:

In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations.

This is not a good start. There were no ‘imbalances’ nor can there be for a nation like the US with floating exchange rates and non convertible currencies.

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances.

He’s saying we should have done more to reduce the trade deficit.

The macroeconomic fundamental is that exports are real costs and imports real benefits.

Reducing our trade deficit reduces our standard of living and real terms of trade.

However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States.

Stuck in loanable funds theory.

He still thinks the US somehow uses ‘imported dollars’ for funding purposes.

He’s got the causation backwards.

Causation runs from ‘loans to deposits’ and not vice versa.

The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets.

So in his world view we get dollars from overseas to invest, and the problem is we failed to do it prudently?

This is not how the monetary system works.

In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad.

Those flows were in external currencies.

Again, he’s got it all very much confused.

When those failures became evident, investors lost confidence and crises ensued. A clear and highly consequential difference, however, is that the crises of the 1990s were regional, whereas the current crisis has become global.

No, the difference was that of external vs domestic currency.

And here is the 7th deadly innocent fraud to be added to my draft:

Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort. In that regard, the Federal Reserve, other federal regulators, and the Treasury Department have stated that they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well in even a severe economic downturn.

Yes, the payments system is useful, as are banks that service deposits and originate and hold loans for housing and consumer credit.

Beyond that, however, little or none of the rest of the financial infrastructure is a necessary to support a ‘sustainable economic recovery’. In fact, the reverse is largely true- it’s the real economy that supports the financial infrastructure. Failure to recognize this means a continuation of nominal wealth flowing to the ‘investor class’ as the economy recovers, while high unemployment helps insure those working for a living struggle with downward pressure on real incomes.

At the same time that we are addressing such immediate challenges, it is not too soon for policymakers to begin thinking about the reforms to the financial architecture, broadly conceived, that could help prevent a similar crisis from developing in the future.

Yes, like doing away with most of it?

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task.

Only because they have been allowed to engage in activities far beyond any concept of public purpose.

In light of the importance of money market mutual funds–and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses–policymakers should consider how to increase the resiliency of those funds that are susceptible to runs.

No, policy makers should consider alternative funding models, such as a return to using banks- the designated agents of the Federal Reserve- to accommodate lending and depository functions deemed to serve public purpose.

Procyclicality in the Regulatory System

It seems obvious that regulatory and supervisory policies should not themselves put unjustified pressure on financial institutions or inappropriately inhibit lending during economic downturns.

Banks are pro cyclical, as is the private sector in general, and forcing them to act otherwise is counterproductive.

Only the public sector can act counter cyclically, and should stand by to do that to sustain aggregate demand, output, and employment at desired levels.

Another potential source of procyclicality is the system for funding deposit insurance.

Why not eliminate it entirely??? What public purpose does it serve???

The financial crisis per se was the direct result of people not making their payments for a variety of reasons.

The direct way to address it was to restore aggregate demand from the ‘bottom up’ rather than from the ‘top down’.

That’s why I was recommending an immediate payroll tax holiday, revenue sharing with the states on a per capita basis with no strings attached, and a federally funded, $8 per hour job that included full health care benefits for anyone willing and able to work.

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